Stress in Market Plumbing Contained as Greece Firewalls Hold

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As Greece shuts its banks and imposes capital controls, stress measures in financial markets show the threat of contagion is limited.

While Greek bank bonds tumbled and a credit-risk benchmark in Europe jumped, indicators of banking stress across the continent and in the U.S. suggest relative calm as concern mounts that Greece will exit the euro. The U.S. two-year interest-rate swap spread, a key measure of risk for banks, rose Monday only to a high matched last week.

The relatively muted effect on markets reflects investors’ confidence in firewalls erected to contain the fallout of a potential Greek default during months of debt talks. The European Central Bank has already been buying bonds under its quantitative-easing program and has additional crisis tools put in place in the past few years.

“There isn’t the immediate knock-on effect for banks across the world as they really don’t hold Greek debt,” said Peter Tchir, head of macro credit strategy in New York at Brean Capital LLC. “The ECB is going out of its way to support even Greece, and has much more tools and willingness to respond and also support Spain and Italy. So, the contagion risk is far lower.”

Capital Controls

Greece imposed capital controls early Monday, shuttered financial markets and closed banks until at least July 6, the day after Greeks will vote in a referendum on proposals needed to restore bailout aid. Prime Minister Alexis Tsipras called for the vote before the June 30 expiry of the current bailout and a $1.7 billion payment due to the International Monetary Fund.

The Bloomberg U.S. Financial Conditions Index, meanwhile, still shows a favorable backdrop in markets. The measure, which combines several closely watched gauges of stress across bond and equity markets, was 0.386 on Monday, down from 0.54 on June 26 and up from 0.107 in January. A positive reading indicates risks are lessening.

“This has been on the agenda for such a long time so the contagion that was feared a number of years ago seems unlikely,” said Zane Brown, a fixed-income strategist at Lord Abbett & Co. in Jersey City, New Jersey, which has $137 billion in assets under management. “We have not seen any evidence in terms of higher credit default spreads by other countries or by their banks.”

Market Measure

The difference between the rate on a two-year interest-rate swap and Treasury yields, the swap spread, rose to 24.5 basis points Monday, from 22.63 on June 26.

The gauge reached 167 basis points in October 2008 amid the global credit freeze that followed the collapse of Lehman Brothers Holdings Inc.

U.S. stocks fell the most in two months Monday, with the Standard & Poor’s 500 Index down 1.3 percent New York.

Germany pushed Greece “a little too far” during negotiations over rescue aid, said James Rickards, chief global strategist at West Shore Funds. Rickards warned about the dangers of contagion if Greece’s situation deteriorates, including possible social unrest, which he called the “real wild card.”

“These things can take a year or more to play out,” Rickards said, citing the 1997 Asian financial crisis that began in Thailand before spreading throughout the world and the global financial crisis that he said started in 2007. “I wouldn’t underestimate contagion.”

While global equities fell as investors fled risky assets, the euro erased its losses against the dollar on speculation the fallout from Greece will be contained.

A measure of how much banks expect to pay to borrow in euros, known as the FRA/OIS spread, rose to 15 basis points on Monday. That’s still less than a quarter of the 80 basis points reached at the end of 2011 and down from 18 basis points on June 15.

“It’s in no one’s interest to let the system they spent the last three years trying to salvage to go quickly and easily,” Brean Capital’s Tchir said. “This time, you won’t have a situation that one default causes all these cross defaults. People have all learned so many lessons.”

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